Charitable Gifts Using Illiquid Securities - The New York Community Trust, 21 April 2010

The economic climate over the past couple of
years—with fewer individuals owning highly appreciated stock—has
encouraged donors to consider contributing assets other than publicly
traded securities and cash to their favorite charities. For professional
advisors with clients who have these unusual assets, determining the
most tax efficient and advantageous way to make these contributions can
be challenging. This article discusses income tax considerations in
donating illiquid securities to a charity. It is the first issue of a
three-part series discussing charitable gifts using unusual assets.

Gifts of Illiquid Securities

Some of the more common gifts of
illiquid securities include stock of closely held corporations and S
corporations, restricted stock, and certain stock options.

General Considerations

A donor’s tax treatment for gifts of
illiquid securities depends on the type of security that is contributed
and the type of charity to which the security is contributed. Code
Section 170(e)¹ provides that the deductible amount for a
contribution of property is the value of the property, reduced by (i)
the amount of gain that would not have been long-term capital gain if
the property had been sold at its fair market value and (ii) in the case
of a contribution to or for the use of a private foundation, the amount
of gain that would have been long-term capital gain if the property had
been sold at its fair market value.

Accordingly, when a donor
contributes capital gain property, property that may or may not be
illiquid and has been held for over a year, to a public charity, the
donor can take a charitable income tax deduction for the donation based
on its fair market value, which includes any appreciation of the asset,
and can avoid tax on the capital gain.

By contrast, only gifts of
“qualified appreciated stock” qualify for a full fair market value
deduction when contributed to a private foundation. Code Section
170(e)(5) defines qualified appreciated stock as stock of a corporation
for which market quotations are readily available on an established
securities market, and which is a long-term capital asset. Consequently,
gifts to a private foundation of illiquid stock, such as restricted or
closely held stock, are not treated as gifts of qualified appreciated
stock, and the deduction is limited to the donor’s cost basis. Even if
the stock donated is qualified appreciated stock, if the total amount of
stock contributed, including all past contributions, exceeds ten
percent of all of the outstanding stock of the corporation, the donated
stock in excess of ten percent of the value of the outstanding stock
will not be considered qualified appreciated stock.

The Code
generally permits a charitable deduction of up to 30 percent of a
donor’s adjusted gross income for gifts of capital gain property, such
as stock, held for over a year, to a public charity. A gift of such
stock to a private foundation is deductible only up to 20 percent of a
donor’s adjusted gross income. If the amount of a charitable
contribution exceeds the allowed percentage of the donor’s adjusted
gross income, the donor will be entitled to a carry forward of the
deduction for the next five taxable years. Securities held for less than
one year may also be donated, but the deduction is limited to the
lesser of cost basis and fair market value.

Stock of a Closely Held Corporation

Individuals
who own interests in closely held corporations, i.e., corporations with
a small number of shareholders who generally are actively involved in
managing the business, can realize substantial tax savings if they
contribute their appreciated stock to a public charity. Giving stock of a
closely held corporation requires careful planning. A key concern for
the donor who gives stock of a family-owned or other closely held
corporation to a charity may be having an outsider who is not related to
the other owners as a stockholder. In addition, the charity generally
has no desire to be saddled with illiquid securities. To address these
concerns, the company may redeem the charity’s stock at fair market
value after the gift is completed.

In this type of transaction,
the donor can take a deduction equal to the fair market value of the
contributed stock. Assuming the stock has appreciated in value, the
donor will not have to recognize the appreciation as gain.²
The redeemed shares are carried at cost on the corporation’s books, so
if the corporation had an accumulated earnings tax issue requiring it to
pay a dividend before the redemption, its excess earnings may be
reduced or eliminated depending on the share of the earnings that were
attributed to the redeemed stock.

The contribution and redemption
must occur without any sort of prearrangement between the donor and the
charity. In other words, the transaction must be accomplished without
any preexisting binding obligation either on the charity’s part to
tender the stock or on the corporation’s part to offer to redeem the
stock. Failure to structure the gift properly will convert the
transaction into a sale of the stock by the donor (with a corresponding
tax on the gain), followed by a gift to charity of the proceeds.

In
addition, donors who are shareholders of corporations that are
contemplating termination, liquidation, or merger should consider
contributing all or part of their shares prior to any formal decision.
This timing avoids income tax on the gains allocable to the contributed
shares, effectively providing for charity out of pre-tax dollars.

Notably,
although a donor can also contribute stock of a closely held
corporation to a private foundation, this contribution may trigger the
excess business holdings excise tax rules because donors commonly own a
substantial percentage of the corporation’s stock (i.e., more than 20
percent). Donors may instead consider donating to a public charity, such
as a community foundation, which is not subject to the private
foundation excise taxes.³

If a redemption or sale of
the stock is impractical, a donor can effectively control contributed
stock through the use of a Charitable Remainder Trust (CRT), a trust in
which the income first goes to beneficiaries for a term and the
principal then goes to charity. CRTs allow a deduction upfront
calculated by reference to the present value of capital gain property
donated to a public charity with the same five year excess deduction
carry forward. When the assets can be sold, the donor can avoid capital
gain taxes. Donors using CRTs should be aware that the various federal
tax rules that apply to private foundations also apply to CRTs.

A
Charitable Lead Trust (CLT), a trust from which the income is first
donated to a charity, and then, after a specified period of time, the
principal is distributed to individual beneficiaries, may not be as
appealing as a CRT, but it may provide some planning opportunities for
certain donors. In the grantor form of the CLT, in which income,
deductions, gains, and losses are all contributed to the donor, he can
take an upfront charitable deduction. In the more common nongrantor form
of the CLT, the trust is taxable on its income and takes a deduction
for amounts distributed to charity. In both forms, the income or gains
are fully taxable to the donor or the trust itself. The CLT lets the
donor maintain greater control over the contributed stock and, in the
non-grantor form, may be useful for a donor trying to reduce or
eliminate transfer or estate taxes in transferring the remaining amount
of the trust to his heirs. As with CRTs, donors using CLTs should be
aware that the private foundation rules generally apply to CLTs, with
certain exceptions.

Stock of an S Corporation

Philanthropic
opportunities are also available for owners of so-called S corporations.
These small businesses operate as corporations, but are treated as
partnerships for tax purposes. They have a maximum of 100 shareholders
and only certain people are eligible to become shareholders. Generally, S
corporation stock is treated much like closely held stock, with a few
significant differences.
 
When evaluating a gift to charity, a
donor of S corporation stock should be aware of the types of assets held
by the corporation, especially appreciated inventory or unrealized
receivables. A charitable deduction for a gift of appreciated property
must be reduced by the amount of “ordinary income” that the donor would
have had if the donor had sold the property. Code Section 170(e)(1)
governs these kinds of contributions and provides that “rules similar to
the rules of [Code] section 751 shall apply in determining whether gain
on [S corporation] stock would have been long-term capital gain if such
stock were sold by the taxpayer.” Consequently, the donor’s deduction
for a contribution of S corporation stock, in most instances, will not
be the full value of the stock, but will be reduced to the extent of the
donor’s share of the S corporation’s appreciated inventory and
unrealized receivables, including depreciation recapture.

All
items of income and gain passed through to the charity during the period
that it holds the S corporation stock will constitute unrelated
business taxable income. In addition, any gain upon the charity’s sale
of the stock will be subject to tax. As a result, the value of the S
corporation stock to the charity can be effectively diminished by the
amount of tax liability that the charity must bear. This potential
liability may affect the charity’s willingness to accept S corporation
stock.

Although a charity may hold S corporation stock, the tax
law currently prohibits CRTs and some CLTs from holding S corporation
stock (the grantor form of the CLT may hold S Corporation stock). The
transfer of S corporation stock to a CRT or certain CLTs will
automatically terminate the S corporation status of the corporation, and
make it taxable as a C corporation.

Instead of an individual
owner donating S corporation stock, the S corporation itself can donate
assets to charity. The gift is treated as if made on a pro rata basis by
the shareholders and is subject to their individual contribution
limits. Generally, the shareholder’s basis is reduced pro rata by the
fair market value of the property contributed by the S corporation. The
charitable deduction that a shareholder can take is limited to the basis
in her shares. Deductions that are unused because of this basis
limitation may be carried forward indefinitely.

Restricted Stock

Sometimes stock is subject to
restrictions on sales imposed by the Securities and Exchange Commission
(SEC), by agreement with an underwriter, by the corporate charter, or
by a shareholders’ or other agreement. These restricted securities
usually trade at a discount in relation to freely traded securities
because of the restrictions. Restricted stock can be donated to public
charities in much the same manner and can often produce the same tax
consequences as closely held stock discussed above.

But donating
restricted stock raises additional issues in determining the amount that
a donor can claim as a charitable deduction. The IRS has ruled
privately that stock subject to Rule 144 (i.e., restricted stock of a
type that is publicly traded, but which is not readily marketable under
SEC rules), is not “qualified appreciated stock” under Code Section 170
for purposes of a contribution to a private foundation because market
quotations were not readily available on an established securities
market. As a result, the donor’s deduction was limited to his basis in
the stock. The ruling also noted that the value of the stock was less
than the value listed on the established securities market because it
was subject to resale restrictions. (Private Letter Ruling 9247018)

In
a ruling involving a contribution of stock subject to Rule 144 volume
restrictions to a private foundation, the donor agreed to restrict his
own sales so the volume restriction would not apply to prevent a private
foundation from selling the shares, and the IRS held the stock was
qualified appreciated stock, deductable at fair market value. The IRS
found that the restricted stock could be considered qualified
appreciated stock because the shares that the foundation received would
be freely transferable immediately upon receipt as a result of the
agreement between the donor and the foundation. (Private Letter Ruling
9734034)

A donor should consult with a tax advisor to determine
whether a full fair market value deduction is appropriate for a
contribution of restricted stock to a public charity or a private
foundation. To the extent that the restricted stock requires the charity
to make certain representations as a new investor before the donor can
contribute the stock, the donor should ensure that the charity can make
such representations.

Stock Options

Instead of contributing stock
itself, a donor can contribute stock options, rights to buy or sell
shares of stock at a guaranteed price during the life of the option.
Before donating options, a donor must first review the terms of the
option plan to determine if an option transfer is even possible.

A
living donor cannot donate incentive stock options (ISOs), which are a
type of employee stock option granted only to employees and which confer
a significant tax benefit. If the option plan permits, the ISOs can be
given as a bequest, which would generate a charitable deduction for the
estate. Alternatively, a donor can exercise the ISOs and give the ISO
shares as an inter vivos gift.
If the donor has held the shares for the requisite holding period,4 she
can claim a fair market value deduction and avoid recognition of any
capital gain. Importantly, donating ISO shares before the expiration of
the required ISO holding period will completely erase the donor’s
favorable tax treatment and cause her to recognize income at the time of
the gift. Notably, with this type of gift, Alternative Minimum Tax
(AMT) concerns may arise and a donor should review her tax situation to
determine whether the AMT will apply.

On the other hand, a donor
can transfer nonqualified stock options (NSOs), which are options
granted to employees or service providers to purchase shares of stock at
a fixed price, during his lifetime. NSOs generally do not have a
readily ascertainable value at the date of grant, and the employee or
service provider will be subject to tax only at the time of exercise
(even if donated to a charity). Donating NSOs can be problematic,
however, because NSOs generally generate income to the donor upon
exercise, and a possible timing difference exists between the
recognition of income and the completion of the gift for purposes of the
charitable contribution deduction. In other words, the charity’s
exercise of the option, although it results in income to the donor, does
not necessarily occur at the same time as the event triggering the
charitable deduction for the donor. Because the donor may not know
exactly how much income he will recognize or the value of the charitable
deduction, it may be better for the donor to first exercise the NSOs
and then donate the proceeds to charity.

If instead the donor
donates the shares received from exercising an NSO, he will be allowed a
charitable deduction that can be used to offset the income recognized
at exercise. The deduction will be equal to either the donor’s basis in
the shares (offset up to 50 percent of adjusted gross income) if the
shares are transferred within 12 months of the exercise date, or fair
market value (offset up to 30 percent of adjusted gross income), if the
donor transfers the shares after 12 months. Because of the complexities
involved in contributing stock options, donors should consult with their
tax advisors to determine the most tax-effective way to make such
donations.

Substantiating the Gift

In order to claim a
deduction for contributing any of these illiquid securities, a donor
must substantiate the contribution with a receipt from the charity
showing (i) the name of the charity; (ii) the date of the contribution;
and (iii) a reasonably detailed description of the property. In
addition, if the donor claims a charitable deduction for more than $500,
she must receive and keep an acknowledgment of the contribution, and
maintain written records that substantiate the manner and date of
acquisition of the stock and the cost or other basis of the stock.

Valuing the Gift

Appraisals

The IRS generally requires an appraisal made by a
qualified appraiser of any contributed property, other than publicly
traded stock, valued over $5,000. A donor does not need an appraisal if
the property is non-publicly traded stock worth $10,000 or less.
Accordingly, only gifts of closely held stock and restricted stock for
which the donor claims a deduction of more than $10,000 require a
qualified appraisal. A donor’s failure to obtain an appraisal will
disqualify a charitable deduction to the extent of the donor’s basis.

A
qualified appraisal must be made by a qualified appraiser in accordance
with generally accepted appraisal standards, and must meet the relevant
requirements of Section 1.170A-13(c)(3) of the Regulations and Notice
2006-96. A qualified appraiser is an individual who has either earned an
appraisal designation from a recognized professional appraiser
organization or has met certain minimum education and experience
requirements. For appraisers of property other than real property, the
appraiser must have successfully completed college or professional-level
coursework relevant to the property being valued, have at least two
years of experience in the trade or business of buying, selling, or
valuing the type of property being valued, and fully describe in the
appraisal her qualifying education and experience. The individual must
also regularly prepare appraisals for pay, and must not be prohibited
from practicing before the IRS at any time during the three year period
ending on the date of the appraisal. The donor, the donee, or the
taxpayer who claims the deduction is not a qualified appraiser with
respect to the contribution.

The appraisal may not be made
earlier than 60 days before the date of contribution of the property,
and no part of the fee arrangement can be based on a percentage of the
appraised value of the property. A separate appraisal is needed for each
item of property that is not included in a group of similar items of
property.

If the claimed deduction for an item of donated
property is more than $5,000, the donor must attach Section B of IRS
Form 8283 to her tax return. If a donor claims a deduction of more than
$500,000 for a contribution of property, the donor must not only attach
Section B of Form 8283, but must also attach the qualified appraisal of
the property itself. If the donor does not attach the appraisal, she
cannot deduct her contribution, unless the failure to attach the
appraisal is due to reasonable cause and not to willful neglect. Donors
should also be mindful of the timing requirements that exist as to when
the appraisal should be received and when it should be claimed on a
return. When the IRS reviews a return with a gift requiring an
appraisal, it may accept or dispute the appraisal. Donors may be liable
for a penalty if they overstate the value of donated property.

A
donor cannot take a charitable deduction for fees that she paid for
appraisals of the donated property. Still, these fees may qualify as a
miscellaneous deduction, subject to the two percent limit if they are
paid to determine the amount allowable as a charitable contribution. The
charity should not pay for the appraisal unless it can show the cost of
the appraisal as consideration received for the gift. If the gift is to
a donor-advised fund or a supporting organization, the charity may not
pay the appraisal fee.

Special Considerations in Valuing Stock of Closely Held
Corporations (S Corporations) and Restricted Stock

Gifts are valued
as of their date of gift, usually indicated by recent arms-length sales.
Unfortunately, this information is rarely available for these types of
stock. Accordingly, valuing illiquid securities is often quite difficult
and subjective, making the valuation process more art than science.

The
IRS has articulated a number of factors that should be considered when
determining the fair market value of closely held securities, including
the company’s net worth, prospective earning power and dividend paying
capacity, and other relevant factors, including the nature and history
of the business, especially its recent history; the good will of the
business; the economic outlook in the particular industry; the company’s
position in the industry, its competitors, and its management; the
degree of control of the business represented by the block of stock to
be valued; and the values of securities of corporations engaged in the
same or similar lines of business that are listed on a stock exchange.
Appropriate discounts for lack of marketability, minority interests, and
other factors are then applied to establish the fair market value of
the stock.

In terms of valuing restricted stock, the process is
typically more involved than valuing the underlying publicly traded
stock, and the qualified appraisal will likely take into account the
nature and duration of the restrictions. To arrive at fair market value,
the appraiser or the donor, if a qualified appraisal is not required,
will consider certain factors, including the resale provisions found in
the restriction agreements and the market experience of freely traded
securities of the same class as the restricted stock. The IRS recommends
that donors keep complete financial and other information on which the
valuation is based, including copies of reports on the company made by
accountants, engineers, or any technical experts on or close to the
valuation date.

Conclusion

Donors and charities must consider a
number of issues when making and accepting gifts of illiquid
securities, including the timing and valuation of the gift, potential
tax liabilities, and any restrictions on subsequent sale or disposition
of the stock. The New York Community Trust, because of its flexible
structure and knowledgeable staff, is well positioned to handle these
gifts. If your client is thinking of donating illiquid securities
because of a prospective sale or transfer of the business or generally,
The Trust can provide opportunities for integrating long-term
philanthropic goals into a donor’s business planning while generating
significant tax deductions for your client.

For further reference, see:
IRC
Section 170(b)(1)(A): General rule for percentage limitations for
individuals.

IRC Section 170(e)(5): Special rule for
contributions of stock for which market quotations are readily
available.

IRC Section 422: Incentive Stock Options.

IRC
Section 512(e): Special unrelated business income rules applicable to S
corporations.

IRC Sections 1361-1379: Rules governing S
corporations.

IRC Section 4943: Taxes on excess business
holdings.
Treas. Reg. Sec. 1.83-1(c):

Dispositions of
nonvested property not at arm’s length.

Treas. Reg. Sec. 1.83-7:
Taxation of nonqualified stock options.
Treas. Reg. Sec. 1.170A-1(c):
Value of a contribution in property.

Treas. Reg. Sec.
1.170A-13(b): Charitable contributions of property.

Treas. Reg.
Sec. 1.170A-13(c): Deductions in excess of $5,000 for certain charitable
contributions of property.

Treas. Reg. Sec. 1.1366-2:
Limitations on deduction of pass-through items of an S corporation.

Treas.
Reg. Sec. 20-2031-2: Valuation of stocks and bonds.

IRC Section
312: Effect on earnings and profits.

Revenue Ruling 59-60, 1959-1
CB 237.

Revenue Ruling 78-197, 1978-1 C.B. 83.

Palmer v.
Comm’r., 62 T.C. 684 (1974).

Blake v. Commissioner, 42 T.C.M.
1336 (1981), Aff ’d, 697 F.2d 473 (2nd Cir. 1982).

Hewitt v.
Commissioner, 166 F3d 332 (4th Cir. 1998).

Private Letter Ruling
9247018.

Private Letter Ruling 9441032.

Private Letter
Ruling 9734034.

Private Letter Ruling 9825031.

IRS
Publication 526: Charitable Contributions.

IRS Publication 561:
Determining the Value of Donated Property.

Notice 2006-96,
2006-46 I.R.B. 902.

Footnotes

¹ All references
to the Code are to the Internal Revenue Code of 1986, as amended, and
all Regulation
Section references are to the regulations promulgated
thereunder.

² On the other hand, if the stock has
depreciated, it would be better for the donor to sell the stock and then
donate the proceeds to charity, taking both a loss deduction and a
charitable deduction. Donating the depreciated stock would not allow the
donor to take a deduction for the loss; instead, the donor could only
take a charitable deduction for the value of the stock.

³
Effective 2006, the excess business holdings excise tax rules also
apply to donor-advised funds at particular charities. Accordingly,
donors who set up these types of funds at community foundations should
also be mindful of these rules.
4 To obtain favorable tax treatment,
the shares received upon exercise must be held by the employee for at
least (i) two years from the date that the option was granted and (ii)
one year from the date the option was exercised. A three month
employment requirement also has to be satisfied prior to exercise. See
Code Section 422(a)(2).

©The New
York Community Trust 2010
Written by Jane L. Wilton, General
Counsel and A. Nicole Spooner, Associate General Counsel of The New York
Community Trust.

This material was developed by The New York
Community Trust for the use of professionals. It is published with the
understanding that the publisher is not rendering legal, accounting, or
other professional advice.

For more information call Jane L.
Wilton, general counsel, at (212) 686-2563.